Goodwill in a financial sense is the money paid for a business above the value of its tangible assets. When a buyer pays for even a dollar of a company’s goodwill, the buyer is in essence paying that dollar on trust that the business will continue in a similar manner to how it has been operating. As the dollars paid for goodwill increase, buyers follow an ever increasing “trust but verify” approach during due diligence as they request documents which support the seller’s position on value (e.g. backlog is increasing, quoting is strong and/or the production equipment have been regularly serviced). It is often easy to produce reports or locate invoices, which support these statements. A more difficult challenge in due diligence is proving the value of certain assets on the balance sheets in prior years, assets such as inventory, receivables, payables and accrued items. This is where the level of your financial statements comes into sharp focus.
There are three levels of financial statements a CPA can issue: Compilation, Review and Audit. These are briefly described as follows:
Compiled: Financial records from the company formatted in a manner consistent with the presentation prescribed by accounting standards. The CPA does not perform any verification or review of the data other than to adjust for obvious errors or to assist with accounting entries as requested by management.
Reviewed: The compiled statements are enhanced with two additional “tests.” First the statements are reviewed for comparison with prior years to look for potential errors (e.g., a spike or drop in certain accounts). Secondly, entries are tested against internal documents for accuracy, the most basic is comparing the year-end cash balance on the financial statement with the reconciled bank statement at the end of the year. Another simple example is confirming the number of lease payments remaining on a piece of equipment with the invoice from the leasing agent.
Audited: These statements are similar to reviewed statements, however accounts and entries are also verified with outside parties, creating the highest level of assurance. Perhaps you have seen a letter from an accounting firm asking you to verify the amount you owe a vendor as of a certain date. This is an example of outside verification where internal records appear to support a receivable, however additional assurance is being sought from the outside unrelated party as well.
The higher level of service provided by a CPA firm, the greater level of comfort and confidence a buyer will have with the financial information presented. Typically, the more comfortable the buyer is with the data, the more interesting the offer they are willing to make. A buyer’s expectations for level of financial statements are often based on revenues, amount and value of inventory or other more complex issues the target company may have such as revenue recognition. The larger and more complex the target company, the higher level of financial statements a buyer will expect.